Making Bankruptcy Worse

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Fallout from the mortgage meltdown continues to spread, and the economy ails. The statistics dryly tell us of incremental leaps in both the number of home foreclosures and of bankruptcy filings by consumers and small business owners. When we read the statistics we sometimes forget that those numbers tell a human story about people who are affected by those events.

There are three drastic, life altering events that seem to put people at a higher risk of bankruptcy than anything else. These factors are unemployment, serious illness, and divorce. If you suffer just one of these events, there is a higher than normal likihood that you will file bankruptcy.

Was there ever a time when you were late on a bill because you just didn’t have the money? Most people can turn to family, friends or other resources to solve a temporary cash shortfall.

What would happen to you if a personal money problem grew into something so big that no one else could help you solve it? When things get that bad, bankruptcy becomes a rational choice to solve a problem that has no other solution.

Most of the people who can’t pay their debts aren’t flakey. Most can trace their problem to a divorce, the loss of a job, or a serious illness that caused them to stop working. These people didn’t choose that fate, and almost all of them incurred their debts during a time when they had the money to repay what they had borrowed. As we all find out, things in life can change. Very few of us are blessed with a secure lifetime job, perpetually good health, and a perfectly happy marriage. The loss of just one of these pillars frequently brings down the whole roof, financially speaking, and it leads many people down a path that eventually results in filing bankruptcy.

Filing bankruptcy usually brings people automatic relief. The pressure from bill collectors comes to an immediate stop, and in most cases, (called Chapter 7 bankruptcy) the court will actually order the elimination of most debts. In recent times, something like 1.5 to 2 million people each year have filed for bankruptcy protection. Read on, and you will see why most of them did so.

In the early stage of a debt crisis, people are usually in denial that they have any problem. They may buy themselves some time by borrowing from “Peter to pay Paul,” often transferring debt balances from one credit card to pay off another, because that keeps them “current” without actually making a payment that month. The problem with that strategy is that the debt never gets paid off; it just gets shifted to a different lender, often causing the debt balances to inch up ever higher with fees and transfer costs. In the later stage of a debt crisis, a person’s available credit may be all used up, they have no credit left for making further balance transfers, and the game becomes a miserable struggle of juggling overdue payments and dodging the phone calls from creditors.

Observing this end game is like watching the death struggle of a bunny being crushed by a python. Bill collectors can sense when a debtor is sinking fast, and they also sense that they are competing against each other to squeeze out whatever limited money a debtor has left before some other creditor can take it. The strong arm tactics exerted by many bill collectors often become downright vicious at this stage of the collection process.

Despite some weak laws banning hard ball collection tactics, the final collection assault is often a forceful combination punch that threatens the debtor with immediate fearsome legal consequences, (threats to garnish wages, seize bank accounts, car and other assets) combined with heaps of degrading personal abuse. There are very few people that can stand up to such pressure without an emotional meltdown, especially when the collector has you thoroughly frightened. You want to pay it back, but you just haven’t got the money. You feel helpless. You feel humiliated. This stage of the collection process leaves many a borrower holding their phone and weeping in tears of shame, fear and frustration.

That is the exact point when many debtors have simply had enough; they want the protection of personal bankruptcy, even if they don’t exactly know how it works or what it does. They just know that they need it.

Bankruptcy laws in the U.S. have evolved over time to provide a safe harbor where the “honest but unfortunate” debtor may be allowed to discharge most kinds of debts. The actual process entails a fairly complex legal inquiry that is conducted in a United States Bankruptcy Court. To describe this in very simple terms, the process takes place by demonstrating that one’s debts were incurred under honest good faith circumstances and that one is truly unable to pay back any of the money.

Debts that are owed for family support, taxes, and educational loans are generally not discharged and will usually remain owing. There is also a bankruptcy remedy, (called Chapter 13) that may allow someone to restructure most debts on new, better terms and often with no interest.

A complex new bankruptcy law took effect on October 17, 2005. The new law imposes a mechanical “means test” for deciding many of the bankruptcy cases, (instead of allowing a courtroom judge to decide) who is entitled to be forgiven of their debts, and who isn’t. The means test is a mathematical determination that starts by dividing everyone into two classes: those who earn above the median level of income in the state where they live, and those who earn below it.

For people with an income below the median income level of the state where they live, a bankruptcy case generally works out to produce a result that is pretty much the same as what it used to be, albeit with a great deal more legal work and expense than there ever used to be.

For those with a personal income above the median income in the state where they live, relief might still be granted but the bankruptcy calculus moves to a complex computation in which a combination of certain actual living expenses and certain hypothetical living expenses are subtracted from the debtor’s average income that was actually received during the previous six months. If the debtor shows a surplus of income under this formula, then the debtor may be required to give creditors all of their projected disposable income for the next 5 years in a bankruptcy case under Chapter 13.

On the surface, this process may look fair enough. Those who can pay something shouldn’t get a free ride. But in reality, the “means test” has some serious drawbacks as a gatekeeper for debt relief. For one thing, the eligibility process is anchored on a mathematical model of hypothetical living expenses. The use of hypotheticals and a mathematical model to decide the outcome of a law case does not uphold the principal of judging each case on an individual basis. Moreover, the hypothetical living expenses that the law imposes for conducting this “test” is actually the exact same standard that the IRS currently uses as a collection tool against delinquent tax payers.

In addition to using certain artificial living expenses as a measurement, the “means test” also artificially determines a person’s income. The test measures income that the debtor received over the previous six months, even if the debtor doesn’t have that income any more. A person who has suddenly lost a job or become disabled may be kept from filing what would have been a good faith bankruptcy case because the “means test” is imposed on their old income, not the income that they have now. Moreover, the variance in “means test” median income from one state to another can be huge.

Here is an astounding example: a person living in Connecticut can pass the means test and be allowed to file bankruptcy even though that same person earns about $20,000 more than someone who has failed the test and lives in Louisiana.

The median income cutoff to avoid the “means test” for a single person living in Louisiana is currently $33,391. The median income cutoff to avoid the “means test” for a single person living in Connecticut is currently $53,876.

To make matters more complicated, within any particular state these anomalies grow more pronounced. People within the same state having the same identical income can have a completely different outcome in their bankruptcy cases. For instance, under the means test property owners get to reduce their disposable income by deducting the full amount of their actual monthly mortgage expenses; renters fare worse, because they only get a limited standard rent deduction instead of using what they actually pay. A high income earner with a big monthly mortgage payment may be allowed to file, while a renter with the same income may be excluded.

The means test works that way because it was originally formulated by the IRS as a debt collection tool. Understandably, the IRS wants a tool to maximize the taking away of future income from delinquent tax payers who have wrongfully failed to pay their taxes. However, modern American bankruptcy law was created for the opposite purpose, which is to give people who have been “honest but unfortunate” a fresh start. That happens by allowing people to keep their future income free from the burden of insurmountable debt. In fact, modern consumer bankruptcy law is a process that normally helps to immunize an economy from the effects of a serious downturn, such as that which is now being brought on by the mortgage crisis.

Economists know that accessible bankruptcy laws actually create an escape valve that allows troubled consumers to stay in the economic mainstream as self-supporting taxpayers, (instead of dropping out under the pressure of never ending debt collection and wage garnishments). It also fosters entrepreneurship, (risk taking) which creates job formation in new small business enterprises and thus helps an economy to grow.

Writing off the debt that is now discharged in bankruptcy is not a loss to the economy, because most of it wouldn’t have been collected anyway, (you can’t get blood from a turnip.) When any society makes the cost of personal financial failure too great, (thru harsh or inaccessible bankruptcy laws), then those laws make entrepreneurs shun the risk of starting new businesses. Fewer entrepreneurs want to risk being saddled with permanent, inescapable debt. Thus, an economy stagnates.

The current bankruptcy law was enacted at the behest of Big Money, namely the collection departments of the credit card banks. Their idea was quite simple but brilliant: make a new law that is very hard to understand and difficult to administer, fewer people will use it, and bill collectors will have more time to collect more money from more people. Similar legislation was vetoed twice by President Clinton. In 2005, the Congress and the administration enacted this new law, effectively making bill collectors the fox in charge of the hen house.

Expert bankruptcy attorneys have been steadily learning how to guide their clients through the tangle of new rules, regulations and complex forms that are now required for even the simplest bankruptcy case. Debtors who try to brave this system without expert help are courting disaster. The best advice for people with a serious debt problem remains the most obvious; get the best legal representation that you can find. Filling out bankruptcy forms is a good example of something thing you should not try at home with a self-help book.

The current bankruptcy law is now two and a half years old. The law is a bill collector’s dream come true, but it isn’t much good for the consumers and the small business people that keep an economy robust. Foreclosures are raging, energy prices leap skyward, and the dollar has sunk. This is not the time to stifle entrepreneurial enthusiasm. Major economic ills can’t be fixed overnight, but a more rational bankruptcy law would be a modest step in the right direction. It would spur small business investment, foster new job creation, and rebuild consumer confidence.

A practicing attorney since 1979, Mr. Bayer is a founding partner in the law firm of Bayer, Wishman & Leotta (1989) and is a Certified Specialist in Bankruptcy Law by the State Bar of California Board of Legal Specialization.
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